AGNC Investment Corp

NASDAQ:AGNC

Earnings Call Transcript 2017-Q4

[Katie Wisecarver, IR]

Thank you, Phil, and thank you all for joining AGNC Investment Corp fourth quarter 2017 earnings call. Before we begin, I would like to review the Safe Harbor statement.

This conference call and corresponding slide presentation contains statements that to the extent they are not recitations of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of AGNC. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risk Factors section of AGNC's periodic reports filed with the Securities and Exchange Commission. Copies are available on the SEC's Web site at SEC.gov. We disclaim any obligation to update our forward-looking statements unless required by law.

An archive of this presentation will be available on our Web site and the telephone recording can be accessed through February 15 by dialing 877-344-7529 or 412-317-0088, and the conference ID number is 10115477. To view the slide presentation, turn to our Web site, agnc.com, and click on the Q4 2017 Earnings Presentation link in the lower right corner. Select the webcast option for both slides and audio, or click on the link in the conference call section to view the streaming slide presentation during the call.

Participants on the call today include Gary Kain, Chief Executive Officer; Peter Federico, Executive Vice President and Chief Financial Officer; Chris Kuehl, Executive Vice President; Aaron Pas, Senior Vice President; and Bernice Bell, Senior Vice President and Chief Accounting officer.

With that, I'll turn the call over to Gary Kain.

[Gary Kain, CEO]

Thanks, Katie, and thanks to all of you for your interest in AGNC. We are very pleased with AGNC's performance during the fourth quarter as for 2017 in its entirety. Economic return for the quarter was 2.3% which brought the full year economic return to 12.1%.

The key theme from prior quarters remained in place in Q4. Equity markets continue to set new records while valuations of credit sensitive fixed income products improved yet again. The yield curve continued to flatten and interest rate volatility remain muted.

As an illustration of how stable longer term interest rates were in 2017, consider that the 10 year treasury began the year at 2.43% and closed at 2.41%. Even more unprecedented is that the yield on the 10 year closed every quarter of 2017 between 2.3% and 2.41%.

This is an incredibly tight range especially considering materially stronger global growth and three interest rate hikes from the fad in 2017. While the tenure has increase about 30 basis points so far in 2018, we continue to believe rates are biased somewhat higher but there is little reason to anticipate a significant spike in rates similar to the tape or tan from back in 2013 or the move we experienced in late 2016 following the election. To this point, we believe the widespread optimism surrounding the global economy is already largely priced to financial markets.

Turning to agency MBS, we anticipate that spreads could wind somewhat during 2018 as the technical landscape becomes more challenging against the backdrop of a steady decline in Fed purchases. Accordingly we expect levered return to agency MBS to remain attractive an even improve relative to other competing products.

This incremental relative value especially for levered investors should help the market absorb the increase in net MBS supply and in turn mitigate the impact on spreads. As in the side, the higher relative ROE on agency investments is not the only benefit investor should consider when evaluating the agency mortgage REIT space in the current environment.

Agency MBS have the ability to outperform if the economy were to weaken or if the tremendous run we have seen in the valuations of risk assets comes to an end. This counter cyclicality provides a very important diversification benefit to a typical portfolio given that the vast majority of most equity investors' portfolios are heavily biased toward a continuation of the current risk on mindset.

An investment in AGNC is one of the few alternatives investors have at their disposal to achieve equity returns that can hold up even if the current bull market runs out of steam. That said AGNC performed extremely well in 2017 with the total stock return of almost 24%. So, a weaker economy is by no means a necessary condition for AGNC to generate attractive return. With that as the introduction let me turn to slide four and quickly review our results for the quarter.

Comprehensive income totaled $0.44 per share, net spread and dollar roll income excluding catch-up [am] increased in Q4 to $0.63 per share from $0.62 for prior quarter. More importantly as you see on the bottom of slide 22 our net spread and dollar roll income declined only $0.01 per share over the past six quarters despite four interest rate hikes and dramatic flattening of the yield curve. Our very high hedge ratio is a significant driver of this favorable result.

Additionally, we reported that $0.20 of our net spread income came from our TBA dollar roll position. As Chris will discuss the funding advantage on TBAs is currently in line with our longer-term expectations. As a result, our net spread income today is less sensitive to the size and specialness of our dollar roll position.

To be more specific we estimate that if we had replaced our entire TBA position with on balance sheet assets and funded them with repo prior to the fourth quarter. our net spread income would likely have been only $0.02 per share lower than the $0.63 we just reported. I do want to be clear that we have no intention of doing this because the incremental $0.02 is worthwhile given the limited incremental pre-payment risk.

The TBA position also enhances our liquidity and can reduce our aggregate margin requirements. Tangible book value per share declined 0.5% to $19.69 during the quarter with economic return coming in at 2.3%. Additionally, despite the selloff in rates in January our current estimate of tangible book value indicates a year to date decline of only about 1 to 2%. Changes to our leverage and aggregate portfolio size were minimal during the quarter.

Turning to slide six I want to quickly recap some highlights for the full year. Net comprehensive income totaled $2.19 per share. Net spread and dollar roll income was $2.56 per share significantly exceeding the $2.16 in dividends declared during 2017.

As I mentioned earlier economic returns totaled 12.1% and total stock return was materially stronger at 23.7%. In aggregate 2017 was a very good year for AGNC and its shareholders. At this point I'd like to turn the call over to Chris to discuss the market and our agency portfolio.

[Chris Kuehl, EVP]

Thanks Gary, let’s turn to slide 7. As you can see the yield curve continue to flatten during the fourth quarter as the market price in additional rate increases from the Fed. Two-year treasury notes increased 41 basis points while 10-year notes increased only eight basis points in the yield. Agency MBS performed reasonably well during the quarter but LIBOR option adjusted spreads on 30-year MBS plus or minus a few basis points from unchanged versus the prior quarter.

Let’s turn to slide 8. Consistent with that risk leverage, little changed quarter-over-quarter, the investment portfolio balance was 72.8 billion as of December 31st. On the top right of slide 8, you can see that prepayment speeds remain well contained given the combination of our assets action, overall interest rate levels in slower seasonal factors.

Our average CPR for the fourth quarter was 10.1% down 2 CPR from 12.1 last quarter. The average balance of our TBA position was relatively unchanged in Q4 at 18.4 billion. However, the period ending balance was lower as of December 31st at 15.7 billion.

TBA roll-implied financing specialness moderated somewhat late in the fourth quarter. Over the longer run, we expect implied financing rates to average around 10 to 20 basis points through mortgage repo funding and against the backdrop of a low risk prepayment environment we expect to maintain a relatively large TBA roll position.

I’ll now turn the call over to Peter to discuss funding and risk management.

[Peter Federico, EVP and CFO]

Thanks Chris, I’ll start with a brief review of our financing activity. Our funding cost increased during the quarter due to the combination of the fed’s rate hike in mid-December and year end funding pressure. These factors led to higher repo cost for our on-balance sheet assets and similarly higher funding rates for our dollar funded TBA assets.

Specifically, our average repo funding cost for the fourth quarter was 143 basis points up nine basis points from a 134 basis points the previous quarter. We experienced a very similar increase in the applied financing rate in our TBA assets which for the quarter we estimated to be 123 basis points, up 11 basis points from the prior quarter.

Taking these two funding sources together, our average funding costs was the 139 basis points for the quarter, up from a 128 basis points the prior quarter. Our aggregate cost of funds which includes the cost of our pay fix swaps also increased during the quarter but to a lesser extent as our swap expense declined quarter-over-quarter.

This decline was driven by an increase in the received floating leg of our pay-fixed swaps, which improved, as three months LIBOR rose consistent with the Fed’s rate hike. Our swap cost improved five basis points during the quarter and thus offset about half of the increase in our repo and TBA funding.

As a result, our aggregate average cost of funds increased just six basis points during the quarter to a 152 basis points. For your reference, we provide these funding numbers on slide 16 of the presentation.

Turning to slide 10, I’ll quickly review our hedging activity. Given the market dynamics that Gary discussed, we chose to operate with less interest rate risk during the quarter. As such, we increased the size of our hedge portfolio to a little over 64 billion and increased our hedge ratio to 97% of funding liabilities.

We also increased the number of option-based hedges bringing our swaption balance to 6.7 billion at quarter end. These hedges give us greater protection against larger rate moves and higher volatility. The effects of these actions can be seen on Slide 11. As we shown the table our duration GAAP at year end was just 0.1 years, down from 0.4 years the prior quarter. In addition, due in part to our swaption position, our estimated duration gap in the up 100 basis point scenario is just 1.2 years.

Lastly the interest rate risk table on Slide 26, shows a similar reduction in our sensitivity to higher rates. As shown on the table, in the scenario where interest rates increased 100 basis points and assuming no rebalancing actions are taken, our estimated decline in net asset value is relatively small at 6.6%. This sensitivity to higher rates is the lowest projected decline that we have reported over the last 4.5 years.

With that I'll turn the call back over to Gary.

[Gary Kain, CEO]

Thanks, and at this point I would like to ask the operator to open up the lines to questions.

[Operator]

[Operator Instructions] The first question comes from Bose George with KBW. Please go ahead.

[Bose George, KBW]

Thanks for the update on book value since quarter end. Just a follow-up the -- with the moving rates et cetera can you give us some color on incremental returns now versus year end?

[Gary Kain, CEO]

They really haven’t moved too much. I mean mortgages are a little wider but -- I wouldn’t call it significant. They tighten really early at the beginning of year and they sort of have that back. So, it's not a big move in spreads and then the yield increase helps a little but I would say there is an update change here today.

[Bose George, KBW]

In terms of qualifying the return now, is it kind of a low double-digit return?

[Gary Kain, CEO]

Yes, I would -- double-digit there its right around let's say 10% in that zipcode.

[Bose George, KBW]

And then just on the CRT side, just given your comments on spreads there et cetera, is it kind of safe to say you are on the sidelines after the royal?

[Gary Kain, CEO]

Yes, I think that’s a safe comment realistically while we have tremendous confidence in the fundamentals of the -- the housing market and in particular the conforming housing market which we have no credit concerns there. The reality is that the labored investor right now is being squeezed out of that product by long own way funds. And so, I think it's not practical as a matter of fact look we would probably be more likely if the current trends continue to shrink that position rather than growing.

[Bose George, KBW]

And then just one more on leverage. Can you just give us updated thoughts on leverage? It was pretty stable, and you have talked for about that going up overtime, just curious about the kinds of scenarios that could take that number up?

[Gary Kain, CEO]

I'm glad you asked the question, it’s a really good one and I want to be clear, nothing has changed with respect to the comments that I have made over the last year that we see the trend higher and leverage and we are very comfortable with that.

But if you go back to the comments I made at the beginning we do feel the technical landscape for mortgages is going to be a little more challenging this year and so I think we plan to be opportunistic with respect to leverage, so if anything we're in the short run very short run I wouldn't expect it to pick up but that's certainly something that we're focused on and nothing's changed our view that two years from now we'd be operating at materially higher leverage.

[Operator]

The next question comes from the line of Douglas Harter with Credit Suisse, please go ahead.

[Douglas Harter, Credit Suisse]

Thanks. Can you talk about your outlook for what you might do with risk metrics kind of given your commentary that you don't see rates moving substantially higher but also like you just said that technically it’s a challenging landscape and do you think you sort of maintain current lower levels of interest rate risk or is that something you might tighten up further.

[Peter Federico, EVP and CFO]

Hi Doug, thanks for the question, it's Peter. Yeah, as I said we obviously reduced our interest rate exposure in the fourth quarter. We're happy about that given the rate move but we do even though we entered the quarter with a fairly defensive position it is our practice to delta hedge as we get into rate moves.

So far, this year we have actually added to our hedge position a little further as I mentioned, our hedge ratio was about 97% at the end of the fourth quarter, at the end of January it was actually about a 100%.

Then we added a few more options to our mix. We like having a little more optionality in the current environment. those hedges have been relatively cheap and they do give us some protection against outsize moves but as Gary mentioned at the beginning in his prepared remarks we have a sort of a bias for rates to go higher but not too meaningfully so, but we'll continue to operate with a defensive position.

[Gary Kain, CEO]

Just one thing to add which is sort of unique, for us and if you think about the up-rate scenario, Peter discussed in his prepared remarks how our exposure to an up hundred scenario the modeled exposure is lower than it's been in a very long time. And but in addition if you look at slide 11 where we show our exposure to what happens to our duration gap and up a hundred scenario. The 1.2 years is actually lower than we may want to run in that scenario.

So, while we have done some incremental delta hedging to further reduce the exposure to a rising rate environment. At some point if this were to continue we actually might start to go the other way and we'd be a position to do so given kind of our starting point on rates because if we were above 3% we might be very comfortable with the year and a half duration gap, so we feel like we're in a very good position from the perspective of our interest rate risk.

[Douglas Harter, Credit Suisse]

And then I guess just staying on interest rate risk, if Peter you just said kind of about a 100% hedge ratio can you just talk about what you think your sensitivity to the three or so increases that we're going to see this year from a spread perspective.

[Peter Federico, EVP and CFO]

Yeah, well, thanks for that question cause one of the things I think that people look at is our net interest margin as Gary mentioned, we've had five rate moves already and if you look at our cost of funds and our net interest margin that doesn’t give us the whole picture because in that cost of funds measured only includes our swap hedge, it doesn't include all of our hedges. But when you look at our net spread income, it has been remarkably stable at below 60s for several quarters now despite the fed continuing to raise rate.

So overtime what I think you’re going to continue to see is the cost of funds measure to come down a little bit and our net interest margin to come down a little bit because again it doesn’t include all of our hedges but I think you’ll see that our earnings will be fairly stable and that’s really important for us to maintain that high hedge ratio and have essentially the same amount of notional hedges of our treasuries and our swap position as our funding liabilities including both our on balance sheet, repo and our off balance sheet TBA funding.

And you know you have to look at that picture holistically and that’s one of the reason why we gave you that extra information on page 16 of the presentations. So that gives you a break down and you can see exactly the drivers of the net interest margin. But overtime you know we’re going to continue to operate with a high hedge ratio that gives us a lot of protection for our earnings going forward.

[Operator]

[Operator Instructions]. The last question currently in the queue comes from the line of Richard Shane with JPMorgan. Please go ahead.

[Richard Shane, JPMorgan]

I’d love to walk through sort of the scenario that I think I’m hearing from you guys which is an expectation of higher rates in expectation of wider spreads. And let’s just say rates are up 100 basis points, spreads widened at a 100 basis points.

I think what I’m hearing you guys says is that as that evolves you will lever up the balance sheet modestly, effectively lowering the hedge ratio stemming the duration. In that scenario, where do you think ROEs go in the context of where we are today. Do you think that you can actually enhance ROEs in that scenario, maintain them or do you expect some sort of compression?

[Gary Kain, CEO]

It’s a good question, so I would think ROEs will expand noticeably in that scenario. Let me just say, on the projections, you know we are a little varies on interest rates but I would say that we don’t see a 100 basis points move and I think 5o would be from where we are today would probably on the higher side of what we likely, what we could see over the course of the year or maybe even into early next year.

So, on the spread side what I would say is we think the technicals are definitely more challenging. We wouldn’t be surprised to see some spread widening but we absolutely think it will be contained.

Mortgages, the agency mortgages are just being more attractive than most competing instruments already at this point and so what we saw with QE was when the fed was buying treasuries and mortgages, you saw very favorable impacts on other products as people basically bought less of those and more of other things. And so practically speaking one has to assume the same thing is going to happen going in the other direction.

So, you’re not going to see a complete discount -- you are not going to see mortgages completely disassociate from everything else. So, I think spread widening more in the 10 to 50 basis points is more of a practical kind of mindset. But against that backdrop higher yields and wider spreads alone will help ROEs, but then a larger duration gap and higher leverage will even more materially help ROE. So, you could see a pretty significant increase in ROE on go forward purchases if that scenario unfolds as I described.

[Richard Shane, JPMorgan]

Got it, makes sense, and again I agreed your 100 basis points seems pretty aggressive 10, 15 basis points spread widening themes very realistic. Let me ask the question in a different way which is when you think about the next 12 months what would the scenario be that you would love to see? What are you looking your shops for and what's the -- when you think about it to put that bad one feeling that with some of that oh that’s going to be down for us.

[Gary Kain, CEO]

So honestly, I think we would like to see spreads overreact in the short run, or at some point this year to the technical factors which is not out of the question. I think that's a reasonable -- it's definitely possible. And that would give us an opportunity to reset leverage so to speak. So that would be a positive.

I think on the rate side we would like to see the scenario more turnout the way we described in extreme move up in rates while I think would create an opportunity at some point. It's not usually favorable to have extreme volatility for a levered mortgage portfolio.

In terms of the scenario, I don't really want to see, I would say again any extreme move in either direction would be as always challenging when managing a mortgage portfolio and I think our increased purchases of option certainly help in that regard. But a bull flattener probably would not be the best scenario in the short run. But I think that’s not something we envision in the near-term.

[Operator]

We have now completed the question and answer session. I would like to turn the call back over to Gary Kain for any concluding remarks.

[Gary Kain, CEO]

Thank you for joining us on our Q4 2017 call and we look forward to speaking with you next quarter.

[Operator]

The conference has now concluded. An archive of this presentation will be available on AGNCs website and a telephone recording of this call can be accessed through February 15, by dialing 877-344-7529-, or 412-317-0088. And the conference id number is 10115477. Thank you for joining today's call. You may now disconnect.